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There’s been a lot of talk lately about how the global
currency market has become stuck in a tight range, with volatility collapsing
and no clear trends emerging. Judging by the performance of the dollar, this is
no time to be complacent.

The Bloomberg Dollar Spot Index rallied on Tuesday despite a
disappointing report from the Federal Reserve on March industrial production
and capacity utilization. And that’s the point: the dollar has shown
remarkable resilience in recent weeks, holding its value even
as incoming data has fallen short of expectations by the greatest
degree since mid-2017, as measured by Citigroup Inc.’s economic surprise
indexes.

That marks a break from the recent past, when the dollar
tended to move in the same direction as the surprise index. The other thing to
note is that the market is more bearish on the dollar than any time in the past
year, based on the options market. Hedge funds and other large speculators are
paying more to protect against a decline in the greenback than they are for
calls versus the euro and its other major peers, according to Bloomberg News’s
Todd White.

What that means is any bit of good economic news is likely
to spur a reversal of those bets, adding to the upward pressure on the dollar.

A rising dollar isn’t necessarily a good thing for
markets. The big sell-off in stocks in the fourth quarter was partly triggered
by the US currency, which strengthened as the Fed doubled down on its hawkish
rhetoric. Although equities have largely recovered, investors need to keep a
close eye on the dollar. S&P Global Ratings figures that 30 percent of the
revenue of S&P 500 companies comes from outside the US Jodie Gunzberg, managing
director and head of US equities at S&P Dow Jones Indices, calculated that
the S&P 500 rises 3.7 times more from a falling dollar than a rising one.
So, all else being equal, a strong dollar should be a drag on stocks.

The good and the bad for bonds

The dollar has also received support from higher yields in
the bond market, which has cut the odds on a rate cut by the Fed this
year to about 40 percent from almost 80 percent just a few weeks ago. Yields on
the benchmark 10-year Treasury note rose as high as 2.59 percent on Tuesday, up
from this year’s low of 2.34 percent just three weeks ago. Yields are back to
where they were when the Fed made its surprising dovish policy shift on March
20. The jump in yields is generally tied to the notion that the economy isn’t
as soft as first believed, and that a recession isn’t imminent, or at least not
in the cards for this year. There’s also another development that could put
upward pressure on yields: the declining share of purchases by investors
outside the US The Treasury Department said late Monday that foreign holdings
of US government debt rose by $50.6 billion to a record $6.385 trillion in
February. But looked at another way, foreigners own just 40.2 percent of the
$15.9 trillion in marketable US debt outstanding, down from 43.1 percent at the
end of 2016, 46.7 percent five years ago and 51.3 percent a decade ago. This
means the US must rely more on domestic investors to fund a ballooning budget
deficit and debt sales forecast to exceed $1 trillion this year alone. "The
market can spend some time consolidating near current levels over the
short-term, but the medium-term setup continues to point to a trend to higher
yields into late-spring/summer," strategists at JPMorgan Chase & Co.
wrote in a research note.

What exactly is priced in?

Rising yields are also no friend to equities, as we saw late
last year. Even so, stocks managed to eke out a small gain Tuesday as the
strategists at Cantor Fitzgerald said current yields are "still low enough
to lend support to risk assets." That’s probably true, considering that
10-year yields above 3.20 percent in October and November were a major catalyst
of the sell-off in stocks. So, with earnings growth generally flat to lower and
the economy decelerating, what exactly is priced into stocks following the 16
percent rise in the S&P 500 this year, and with the benchmark less than 1
percent from its record high?

The strategists at LPL Financial and Strategis Research
Partners put out a joint report Monday saying that current equity valuations
take into account narrowing corporate profit margins and a sustained period of
subpar economic growth. "We’ve heard calls for lower profit margins for
several years now," John Lynch, the chief investment strategist for LPL
Financial, wrote in a research note Tuesday.

"Those calls will be right at some point, but the
market seems to be quite confident that time has come, suggesting the potential
for a positive surprise." And that surprise could be met with a strong
rally, judging by various measures of positioning in equities by investors.
According to Credit Suisse’s prime brokerage arm, hedge funds’s gross exposure
to US equities is the lowest since the middle of last year relative to global
allocations. "There are huge pools of money sitting on the sidelines,"
BlackRock Chief Executive Larry Fink said a conference call Tuesday to discuss
the firm’s results.

All that glitters isn’t gold

Could the gold market be sensing that better times are ahead
and investors will have less need for haven assets as they transition into
riskier assets such as stocks? Whatever the reason, it’s notable that gold
prices have dropped to their lowest this year, falling to as low as $1,273 an
ounce on Tuesday. In fact, precious metals are having a tough time this year
generally, with the Bloomberg Precious Metals Subindex falling 2.13 percent.
The gauge is down 6.37 percent since late February, while the broad Bloomberg
Commodity Index is up 0.35 percent in the same period. And for those who study
past trading patterns to help forecast what’s ahead, the outlook for gold isn’t
so hot. Gold has been trading below its 100-day moving average since Monday, a
typically bearish signal that could suggest the metal will fall further
after stretching out of its recent trading range, according to Bloomberg News’s
Rupert Rowling and Justina Vasquez. There’s also a tie in to the dollar and
rising bond yields. Since many commodities such as gold are traded in dollars,
a stronger greenback naturally makes owning those raw materials more expensive,
tending to damp demand. Also, gold pays no interest, making it less attractive
in an environment of rising yields.

China believers are proliferating

For proof that investors are starting to believe the
evidence suggesting that China’s economy is strengthening, look no further than
Goldman Sachs. Presumably in response to investor inquiries, the firm on
Tuesday published a research report offering ways investors might profit from
the rebound. The firm recommends going long Australia’s dollar versus the
New Zealand dollar, the Canadian dollar or the South African rand, according to
Bloomberg News’s Susanne Barton. Those crosses provide optimal exposure to
Chinese growth with low sensitivity to commodity prices, risk sentiment or the
risk inherent in the yuan from the ongoing US-China trade talks. Recent reports
on credit growth and consumption bolster the case that China’s economy is
improving, and industrial production and retail sales data slated for release
Wednesday may add to the bullish case, Barton reports. Another believer is
JPMorgan. The firm’s economists wrote in a report Monday that they expect
China’s economy to have picked up in the first quarter, expanding at a 6.4
percent sequential rate. That’s better than the 6.1 percent median estimate of
economists surveyed by Bloomberg.

We know the Fed has downgraded its view of the economy, but
what’s really happening "on the ground?" We may get some clues
Wednesday, when the central bank releases its Beige Book economic report, which is
based on anecdotal information collected by the 12 regional Fed banks from the
end of February through March.

The report will help determine whether the factors weighing
on growth at the end of the first quarter are temporary in nature, according to
Bloomberg Economics. The March jobs report suggested the slowdown, which
stretched from December through much of the first quarter, is starting to fade,
Bloomberg Economics said in its week-ahead preview. "Comments on business
confidence and capital spending plans could shed light on whether the recent
slowdown in investment spending was more noise than signal," Bloomberg
Economics said. The next Federal Open Market Committee meeting is just two
weeks away, on May 1.